How far “below the rate floor” are we?

For banks that have floors on a measurable portion of their variable rate portfolio rising rates could present problem that wasn’t really anticipated. Traditionally loan rate floors are supposed to limit down-side risk, but in this unusually low rate environment the rate floors are essentially making a chunk of the variable rate portfolio behave like fixed-rate…even when rates rise.

[rising rates] could actually hurt banks' margins because so many of the industry's business loans have hit the so-called floor, or the minimal rate a lender and borrower agree to when negotiating a commercial mortgage or property loan. …"Lending rates might not all move up because there are a lot of floors in place…Margins could get squeezed."

It was a good article offering plenty of anecdotal evidence about loans being “below their floor”. The CEO of BNC Bancorp remarked that “most of its commercial borrowers are at a floor rate of 5% to 6% right now. The bulk of those loans are priced at prime plus a half or prime plus one. So they'd be paying a rate of 3.75% to 4.25% if the floor wasn't there.”

I started thinking that it would be nice to know if this experience was typical. Are many other community banks experiencing the same thing? If so, on average how far “below the floor” are their variable rate loans? What is typical? The answers to these questions are critical for community banks to have a better understanding of how rising rates will impact their loan portfolio yields.

We run our A/L BENCHMARKS model for about 200 community banks across the country. As part of the process we collect detail loan data to model portfolio sensitivity. With this detail we can tell if an individual loan is fixed rate or variable rate. If it’s variable rate we know its current rate, pricing index, spread, and its floor (if any). From this information we can tell if a loan is at its floor and how far “below the floor” the index plus spread is.

For 4th quarter 2009 we’ve collected data for over 650,000 different loans. Total dollars of outstanding balance is $39.5 billion. About half of the outstanding balance, around $19 billion, is variable rate. Of these variable rate loans a full 20% of them are currently “at their floor”. For each of these loans we computed what the loan rate would be if the floor wasn’t in place. The difference between this computed rate and the loan floor represents how far “below the floor” the loan is. Or, too look at it differently, how much will the loan index (in this case Prime Rate) have to move in order for the variable rate to price up?

The data shows that loans with floors are on average -185 basis points “below the rate floor”. This means that Prime rate will have to move up more than 185 basis points before these loans will start repricing again. The typical range is -250 basis points below to -75 basis points below (typical range is the middle sixty-percent of all loans with floors). The largest amount below the floor is –775 basis points and the smallest is 0 basis points – meaning the loan index plus spread is currently equal to the floor.

The overall impact of this will vary from bank to bank depending on the portfolio mix – variable versus fixed rate. It also depends on how many loans actually have floors. Again this is bank specific.

Now that we know that Prime rate will have to move up on average 185bp before income on these loans starts moving, it puts a new spin on our understanding of the +100, +200, and +300bp stress-tests…doesn’t it?